Back in December, I recommended that readers “watch their ash” when investing in tobacco stocks. In their hunt for yield in a seemingly yield-less world, investors had bid the price of most tobacco stocks to levels that no longer made sense. Tobacco is a no-growth business and an industry in terminal decline. As a case in point, American teenagers are more likely to use illegal drugs that to light up a cigarette.

In the circular logic of the stock market, the lack of growth is part of what has made tobacco stocks such fantastic investments in recent years. Management doesn’t have to reinvest in the business or to fund an expensive marketing budget. And there are no white elephant projects or unrealistic management spin. They understand the economics of their business, and they do the only things that make sense: they pay out gargantuan dividends and aggressively buy back their shares.

But the key here is investor expectations. Investors had low expectations for the sector and were unwilling to pay up for earnings. Ultimately, the success of any investment depends on the price you pay, and tobacco investors were able to enjoy monster returns precisely because the stocks were cheap.

Well, they’re not anymore. Not by a long shot. By Wall Street Journal estimates, the forward P/E on the S&P 500 is 13.5. Philip Morris International (NYSE:PM) is significantly more expensive than that, and Altria (NYSE:MO) and Lorillard (NYSE:LO) are essentially at the same valuation.

Company

Ticker

Forward P/E

Dividend Yield

Payout Ratio

1-Yr Div. Gr. Rate

Philip Morris International

PM

15.5

3.90%

63%

10%

Altria

MO

13.5

5.10%

83%

7%

Lorillard

LO

13.4

5.20%

71%

19%

Intel

INTC

9.9

4.20%

41%

7%

Microsoft

MSFT

8.6

3.30%

45%

15%

Cisco Systems

CSCO

10

2.70%

23%

75%

This should not be. Tobacco stocks should not be more expensive than the rest of the market.

Yes, all pay significantly more in dividends than the S&P 500, which pays a pitiful 2.0%. But look at the payout ratios. All pay out the majority of their earnings as dividends, whereas the payout ratio of the S&P 500 is less than 30%.

Meanwhile, take a look at the technology stocks at the bottom of the chart. Intel (NASDAQ:INTC), Microsoft (NASDAQ:MSFT) and Cisco Systems (NASDAQ:CSCO) all trade for 10 times or less expected earnings, and all have modest dividend payouts with plenty of room for growth. They pay a little less in dividends than tobacco stocks…but not that much less. And their dividend growth rates are comparable (with the exception of Cisco, whose growth rate is off the charts).

As the Big Tobacco has proven for decades, companies in declining industries can make excellent investments under the right conditions. If you have a dominant market position (think back to Warren Buffett’s “moats”), a conservative balance sheet, and have ample cash flow for share repurchases and dividends, you can do quite well by your investors even in a shrinking market. It’s worked for Big Tobacco investors, and it will work for Intel investors as well.

The same could be said for Microsoft and Cisco. Tech is the new tobacco.

To be fair, tobacco companies have certain advantages that “tobacco companies” like Intel lack. A chemically-addicted clientele, for starters, as well as an unrivaled ability to raise prices virtually at will. Whenever a progressive-minded (or cash-strapped) city decides to hike the taxes on cigarettes, the taxes flow right through to the customer. Not too many companies have that ability.

But that said, I’m betting that Big Tech is a better investment than Big Tobacco. Investors are expecting no growth from Big Tech. So, if actual results prove to be even marginally better than disastrous, investors should enjoy a decade or more of solid gains.

Microsoft and Intel in particular may or may not ever figure out the mobile market. But that’s ok. Given that a zero percent probability is currently priced into shares, mobile success can be thought of as an embedded call option that could end up paying off in a big way. And if that option is never exercised, you’re still getting the existing businesses at “tobacco” prices.

About the author:

Mr. Sizemore has been a repeat guest on Fox Business News, has been quoted in Barron’s Magazine and the Wall Street Journal, and has been published in many respected financial websites, including MarketWatch, TheStreet.com, InvestorPlace, MSN Money, Seeking Alpha, Stocks, Futures, and Options Magazine and The Daily Reckoning.

Comments

I agree in principle that tobacco stocks shouldn't sell for an average market multiple, BUT maybe a reason for this is the astute capital allocation strategies implemented by this industry. In simple terms, these comapnies have bought back shares by actually reducing existing share count, and materially increasing the dividend yearly. They simply have not made capital alocation mistakes. You really can't say the same thing for the acquistion happy management's of MSFT, CSCO, etc. The one such excepetion is IBM, which deservedly receives its market multiple...for a technology company.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.